IRA Alert

Ed Slott

Think twice before deducting IRA losses

Tell clients it usually doesn't pay to jump so many hurdles for such a small tax benefit

By Ed Slott

Mar 1, 2009 @ 12:01 am (Updated 3:36 pm) EST

It's tax time, and more advisers are being asked by clients whether losses incurred in individual retirement accounts are deductible.

The simple answer, of course, is that there is never a deduction for losses within an IRA. Just as the owner of one is not taxed on gains in the IRA when they are earned, he or she cannot deduct losses inside the IRA when they occur.

That said, for tax purposes, it may be possible to deduct IRA losses if all the funds are withdrawn from all the IRAs a client owns. For a traditional IRA, it means that all of the funds from all of a client's traditional IRAs must be withdrawn, including simplified employee pensions and IRAs that use savings incentive matches. The client does not have to withdraw any funds from Roth IRAs or inherited IRAs to claim a loss on the traditional IRAs.

To deduct losses on Roth IRAs, the same rule applies. All funds must be withdrawn from all Roth IRAs.

In general, withdrawing all of the remaining funds from an IRA or Roth IRA solely to claim a tax loss is a poor move, because not only is the tax loss often much less than you might think — or sometimes nothing at all — the client has permanently decreased his or her tax-deferred (or tax-free with a Roth IRA) retirement savings by the amount withdrawn.

Before you advise anyone to withdraw all of their IRA or Roth IRA funds in order to claim a loss, make sure they can deduct that loss. You don't want to have a large taxable distribution and then find out that no loss can be claimed or deducted. You also want to make sure that your client understands that the funds being withdrawn will no longer be in a tax-sheltered account. Those funds cannot go back in, other than in annual IRA or Roth IRA contributions, but those limits are low compared with a large withdrawal that would take years to replace.

Having been cautioned, if your client wishes to continue, the next step is to see if there is actually a loss. Your client will likely say, "Of course there is a loss. Look at my statement. I had $850,000 in my IRA, and now I have $400,000. Isn't that a loss?"

ALL ABOUT BASIS

Yes, that is a loss in value, but for tax purposes, a loss can be claimed only if there is "basis." Basis is money that has already been taxed. If the client received a tax deduction for his or her traditional IRA contributions, your client has no basis, since that money has not yet been taxed. Likewise, any earnings in the account have also never been taxed, so earnings can never be basis.

Basis is created by making non-deductible IRA contributions or by rolling over after-tax funds from an employer plan to an IRA. All Roth IRA contributions are basis since there is never a tax deduction for a Roth IRA contribution. Roth conversion funds are also basis since tax is paid on those funds when they are converted. But earnings in a Roth IRA are not basis, because those funds have not been taxed, even though they may never be taxed.

Since traditional IRAs generally include mostly deductible contributions and rollovers from company plans that were also deductible contributions, it is not likely that a loss can be claimed even if all the funds from all of the traditional IRAs were withdrawn. A loss can be claimed only if there is basis and that basis is higher than the amount withdrawn. It is more likely your client will be able to claim a loss for a Roth IRA since all Roth IRA contributions are basis.

Being able to claim a loss does not necessarily mean you will be able to deduct that loss. There are still additional hurdles.

MORE DIFFICULTIES

You cannot claim the loss if you take the standard deduction. The loss can be claimed only as a miscellaneous itemized deduction subject to the 2% of adjusted gross income limitation. Only miscellaneous itemized deductions that exceed 2% of AGI can be deducted. The loss on an IRA or Roth IRA is included in that total. If the loss is large enough, it could allow your client to itemize deductions.

If you clear this hurdle and your 2008 AGI exceeds $159,950 (or $79,975 for those filing married-separate), part of your deduction can be further limited.

Even if you clear those hurdles, you can lose the deduction if you get hit with the alternative minimum tax.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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